Of Reinhart & Rogoff & the Emperor’s New Clothes

The brutal smashing that Reinhart and Rogoff’s work has taken in the past 24 hours, was inevitable even without the catalogue of serious methodological errors in their paper.

Reinhart and Rogoff’s empirical result posited a clear threshold. Reinhart and Rogoff were clear that  debt-to-GDP ratio above 90% spelled doom for growth. The actual data is far less clear:


There is some correlation, but that correlation was loose enough to suggest that this was just one factor of many, and it never said anything at all about whether high debt caused low growth, or low growth caused high debt, or whether some exogenous factor was causing both. The real questions are all about causation.

Far from being a magical no-growth threshold, the UK experienced some of its strongest growth at a public debt level above 90% of GDP, suggesting very strongly that there are many other factors in play. In general, I would tend to caution against the use of arbitrary thresholds to establish principles in economics, whether that is the debt level necessary to lower growth, or the leverage level necessary to trigger a bank run, etc. The evidence suggests these almost certainly vary on a case-by-case basis.

Of course, much of the pro-austerity case seems to have been built on Reinhart and Rogoff.

Olli Rehn of the European Commission defended austerity as follows:

[I]t is widely acknowledged, based on serious research, that when public debt levels rise about 90% they tend to have a negative economic dynamism, which translates into low growth for many years.

Paul Ryan defended austerity using the same criteria:

Economists who have studied sovereign debt tell us that letting total debt rise above 90 percent of GDP creates a drag on economic growth and intensifies the risk of a debt-fueled economic crisis.

Timothy Geithner too:

It’s an excellent study, although in some ways what you’ve summarized understates the risks.

Lord Lamont of Lerwick (an adviser to David Cameron) agreed:

[W]e would soon get to a situation in which a debt-to-GDP ratio would be 100%. As economists such as Reinhart and Rogoff have argued, that is the level at which the overall stock of debt becomes dangerous for the long-term growth of an economy. They would argue that that is why Japan has had such a bad time for such a long period. If deficits really solved long-term economic growth, Japan would not have been stranded in the situation in which it has been for such a long time.

Doug Holtz-Eakin, Chairman of the American Action Forum:

The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth.

This all feels very much like a case of the Emperor’s New Clothes. Those shining robes that cloaked the austerian case for austerity now and at-all-costs were based on serious methodological errors — as opposed to more nuanced criteria for fiscal consolidation during the boomtime, when interest rates on government debt exceed the unemployment rate. All those serious people who praised Reinhart and Rogoff’s seriousness clearly didn’t read it very well, or study the underlying data. Much more like they formed an opinion on the necessity of austerity now, and looked around for whatever evidence they could find for their preconception, whether Reinhart and Rogoff, or Alessina and Ardagna.

The fact that Reinhart and Rogoff did not, and are still not prepared to issue some clarification to their study to prevent its abuse by austerity-obsessed policymakers is sad given the copious evidence that austerity under present conditions is self-defeating. The fact that their response has so far consisted of defending their very weak conclusions — in full knowledge of the political implications of their work, and how it has been used to justify harsh austerity in very slack economic conditions — is very sad indeed.


Should the Rich Pay More Taxes?

It’s a multi-dimensional question.

The left says yes — income inequality has soared in recent years, and the way to address it (supposedly) is to tax the rich and capital gains at a higher rate. The right says no — that the rich already create more jobs and wealth, because they spend more money, and why (supposedly) should they pay more tax when they already pay far higher figures than lower-income workers?

Paul Krugman made the point yesterday that the tax rate on the top earners during the post-war boom was 91%, seeming to infer that a return to such rates would be good for the economy.

Yet if we want to raise more revenue, historically it doesn’t really seem to matter what the top tax rate is:

Federal revenues have hovered close to 20% of GDP whatever the tax rate on the richest few.

This seems to be because of what is known as the Laffer-Khaldun effect: the higher rates go, the more incentive for tax avoidance and tax evasion.

And while income inequality has risen in recent years, the top-earners share of tax revenue has risen in step:

So the richest 1% are already contributing around 40% of the tax revenue, taxed on their 34% share of the national income. And even if the Treasury collected every cent the top 1% earned, America would still be running huge deficits.

Yet the Occupy movement are still angry. A large majority of Americans believe the richest should pay more tax. More and more wealthy Americans — starting with Warren Buffett, and most recently Stephen King are demanding to pay more taxes.

King writes:

At a rally in Florida (to support collective bargaining and to express the socialist view that firing teachers with experience was sort of a bad idea), I pointed out that I was paying taxes of roughly 28 percent on my income. My question was, “How come I’m not paying 50?”

How come? Well, the data shows pretty clearly that it’s unlikely that revenues would increase.

They may have a fair point that capital gains above a certain threshold should probably be taxed at the same rate as income, because it is effectively the same thing. And why should government policy encourage investment above labour by taxing one more leniently?

But more simply, people like King think the status quo  is unjust far beyond the taxation structure. A lot of people are unemployed:

A lot of people are earning less than they were five years ago:

28% of homeowners are underwater on their mortgages. Millions of graduates face a mountain of student debt, while stuck in dole queues or in a dead end job like Starbucks.

We live in dark times.

From Reuters:

Nearly 15 percent of people worldwide believe the world will end during their lifetime and 10 percent think the Mayan calendar could signify it will happen in 2012, according to a new poll.

With all this hurt, there’s a lot of anger in society. Those calling for taxing the richest more are not doing the same cost-benefit analysis I am doing that suggests that raising taxes won’t raise more revenue.

But they’re not unfairly looking for a scapegoat, either. While probably the greatest culprits for the problems of recent times are in government Americans are right to be mad at the rich.


This isn’t about tax. This is about jobs, and growth.

The rich, above and beyond any other group have the ability to ameliorate the economic malaise by spending and creating jobs, creating new products and new wealth. The top 1% control 42% of all financial wealth. But that money isn’t moving very much at all— the velocity of money is at historic lows. It should not be surprising that growth remains depressed and unemployment remains stubbornly high.

And every month that unemployment remains elevated is another month that the job creators are not doing their job. Every month that the malaise festers, the angrier the 99% gets.  It is, I think, in the best interests of the rich to try and create as many jobs and as much wealth as they can.  A divided and angry society, I think, will find it even more difficult to grow and produce.

America needs the richest Americans to pay more tax dollars — but as a side-effect of producing more, and creating growth.

If the private sector doesn’t spend its way out of the current depression, eventually the government will have to, of course. But it can do that with borrowed money, not taxed money.